Academic journal article International Journal of Business

Asset Allocation and Section 529 Plans

Academic journal article International Journal of Business

Asset Allocation and Section 529 Plans

Article excerpt


Previous research has concluded that prespecified asset allocations used by many Section 529 college savings plans are not only suboptimal, but that they are also so conservative that many investors would do better by avoiding such plans entirely. Recent changes in the tax code and in the rules of many states' Section 529 plans alter these conclusions in important ways. In addition, by focusing on the investment options available within the plan, previous research tends to deflect attention from other useful investment options and strategies. In particular, it tends to shift focus away from the rest of the investor's portfolio. This shift in focus tends to obscure strategies that investors can use to avoid some of the remaining investment restrictions imposed by various plans, and can also cloud implications for regulators and designers of these plans.

JEL: G11, G20, G29

Keywords: Asset, Allocation, College, Savings, Taxes, Section 529 Plan


Recent changes in the United States' tax code have raised Section 529 plans to the forefront of investment vehicles for college savings. Legislation has increased both the investment limits and tax benefits of these plans. Not surprisingly, the number of investors using Section 529 plans and the amounts invested in them have grown rapidly. Block and Waggoner (2002) report that about $25 billion flowed to such plans in 2002, and the figure is expected to balloon to $200 billion by 2007.

Academic researchers have begun to explore the topic. For example, Spitzer and Singh (2001) compare Section 529 plans having predetermined asset allocations with investments held outside a tax-preferred vehicle. They provide a concise review of the theory of asset allocation and a brief introduction to the essentials of Section 529 plans. Their concern is that the tax advantages of a 529 plan might be negated by the reduced return resulting from predetermined (more accurately, conservative) asset allocations. They study historical returns and conclude that this may well be the case, especially for investors in low marginal tax brackets and for those who delay investing until the child is nearly ready for college.

My paper extends this previous research in three ways. First, it updates the analysis to allow for recent changes in tax law and the expanded menu of investment options for Section 529 plans that is available today. Second, it shows that the new tax law makes it important to separate the consideration of prespecified asset allocations from the tax advantages of Section 529 plans. (The essential points of this article also apply to most other tax-advantaged investment vehicles, as well). Put somewhat differently, the decision to allocate funds to a 529 plan is now essentially independent of the allocation within the plan. Third, and closely related to this second point, I expand the analysis to include portfolio considerations rather than viewing Section 529 plans in isolation. Taken together, these three extensions offer new insights into the value of Section 529 plans. Most investors are likely to find that previous investment advice should be reexamined in the light of this evidence.

For example, Spitzer and Singh (2001) correctly question the wisdom of prespecifying asset allocations, then proceed by considering a small number of specific preallocations. They compare New York's 1999 College Savings Program with an unrestricted, fully taxable investment. While this approach had some merit in 1999, the conclusions drawn from that study are now potentially misleading. For example, they state all of the following:

"... adherence to prespecified asset allocation for low tax bracket investors often results in return loss that overshadows the tax benefit." (p. 101).

"This evidence strongly suggests that for families in the 'low' income category, which have a long term college savings goal, the [529 plan] is likely to be an inferior alternative to a plan which aggressively contributes to a 100% equity plan. …

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